The Future of Central Banking: Inflation Targeting versus Financial Stability

The future of Central Banking could be summarized as: i) Despite the current scenario which is impairing their credibility, the Central Banks will remain the most powerful and influential economic institution; ii) Presently, there is a transition towards the multiple goal approach, which will include financial stability and, possibly, other objectives as well, such as growth and exchange controls. Hopefully, inflation should remain as the main objective; iii) An important trade-off: the multiple goal policy reduces the effectiveness of the Central Bank’s key role in managing expectations; iv) There will be an increasing need for additional monetary instruments over and above

The global financial crisis has made central banks in the advanced economies “rediscover” the importance of financial stability. In the emerging market economies, in contrast, central banks have always regarded financial stability as one of their central responsibilities. In fact, a number of monetary policy instruments now called “heterodox” or “non conventional” in the context of the advanced economies, have been utilized for decades by central banks in emerging markets (e.g., liquidity or reserve requirements). The recurrent episodes of financial turbulence forced central banks in emerging markets to focus on financial stability, while in the advanced economies (under the influence

Central banks are now being given the task of maintaining financial stability as well as hitting inflation targets.  With two objectives there needs to be, optimally, two instruments that can be used separately for those purposes.  It remains essential for central banks to predicate interest rates primarily for the achievement of stable prices, i.e. hitting the inflation target.  The need is to find an additional set of instrument(s) that can allow them simultaneously to maintain financial stability.  Such instruments have been identified, and include such measures as state-varying capital and liquidity ratios, loan-to-value and loan-to-income ratios in the property market,

The Challenge Unconventional monetary central bank policies after the GFC (i.e., Fed’s QEs and ECB’s outright monetary transactions) have supported asset prices and restored some market confidence so far, but will they succeed in engineering more robust and sustainable economic growth, employment, and financial stability over the medium term? If yes, “inflation targeting” would surely loose its flavor, but if no, should central banks return to “inflation targeting” framework as a means to restore economic and financial fundamentals? Unconventional monetary policies are unlikely to succeed in restoring robust economic fundamentals and lasting financial stability over the long term. In the

Central Banks have to further develop a fully-flexed framework of macroprudential surveillance. This framework has to allow for a broad assessment for the build-up of financial imbalances even if inflation and inflation expectations remain subdued. This monetary policymaking strategy should also include a profound surveillance of money and credit developments and crosscheck the results against other analyses. This guarantees the symmetry of policy in expansions and contractions. ”Ultimately, this cross-check leads to a better assessment of the correctness of the policy stance. Early indications that a process of surging equity or house prices in the euro area might be interacting